When analyzing any law, it’s important to look at the original text, the
governing body that oversees it, and how it’s been interpreted over
time. Despite 90 years of securities case law, legal opinions on
cryptocurrencies are still developing. The SEC is still wrapping their
heads around this rapidly evolving space. While it’s popular amongst the
web3 community to hate on traditional finance and the government, we
have to recognize that it is the mandate of the SEC to protect investors
(which I’d hope we can all agree is important) and that crypto has not
come without its share of fraudulent token sales.
The information expressed here is not a formal legal opinion. Do your
own research - and if you think that your unique use case requires
expert guidance, go get it. We are happy to recommend some firms that
are well versed in this space.
This article is focused on the US, but we will continue to update it with relevant information on other regions as we do more research.
Every securities discussion begins at the Howey test. While the landmark
securities laws were enacted in
response to massive losses during the Great Depression, they weren’t
pressure tested until 1946. In the 1940s, the Howey Company sold tracts
of citrus groves to investors with the promise that the company would
tend the land and share in the profits with investors.
The Howey company, thinking (or hoping) that these arrangements did not
constitute an investment contract, failed to register this offering with
the SEC and make the necessary disclosures to investors. The courts
disagreed - and in doing so established a 4 part test to determine
whether future products are investment contracts (and therefore
An investment contract involves:
Following these rules, the Howey Company's investment product was a
The citrus groves required an investment of money into the common
enterprise that is the Howey Company. There was an expectation of
profit from the sales of citrus, and those profits depended on work done
by the Howey Company tending the fields and taking the fruit to market.
The SEC requires new security offerings to be registered with a
prospectus that informs the public about the nature of the offering and
the company behind it. The prospectus also includes audited company
financial statements, information on key members, and the risks behind
the investment. If the SEC approves the registration, and the company
hosts a successful fundraise, they are required to file annual 10-Ks and
quarterly 10-Qs. All this to say that it’s not impossible to formally
register with the SEC, but producing audited financial statements and
the ongoing reporting requirements can be onerous.
The SEC does allow for some exemptions to securities registration requirements. But to qualify for one of these exemptions, you need to limit your offering to accredited investors and there can be no general solicitation or advertising. You can read more about private placement exemptions here .
Fiat currencies, while often traded for profit (the average foreign
exchange daily trading volume is $6.6 Trillion!) are not considered
securities because their primary purpose is to be used as a form of
payment. They don’t have intrinsic value other than their ability to be
traded for other goods.
The SEC classified Bitcoin as such and it is therefore not considered a
security. Ether, the utility token behind the Ethereum block chain, is
not as commonly used for payments (although the same could be said for
Bitcoin). However, since the Ethereum block chain is sufficiently
decentralized, and continued development doesn't depend on a core
centralized group to work and promote the value of Ether, it too is not
a security. [
It’s this point, relating to part 4 of the Howey test, that is particularly relevant for our discussion of DAOs. We’ll touch more on this in the “How should we structure our token sales to avoid scrutiny?” section below.
Art, while widely speculated on and sometimes worth millions, is not
commonly regulated as a security. The thinking is that art is traded for
the intrinsic value of its beauty even if investors also may seek to
earn a profit. Moreover, thinking back to the Howey Test, while the
creation of the artwork at one time depended on the effort of others,
once completed any future appreciation will not depend on continued
efforts from the original artist.
Applying this to NFT projects, digital art that can be appreciated for
its intrinsic beauty is unlikely to be considered a security. But an NFT
project, where the NFT represents ownership rights to a project, and the
success of the project depends on the development efforts of a core team
or company, may very well be a security.
Things get even more complicated when shares of artwork are fractionalized and shared. Masterworks, a platform set on democratizing the rare art market through fractional ownership of famous pieces, files its offerings with the SEC. Investors in Masterworks depend on the company to determine the investment strategy and primarily benefit by the return on their investment as they do not actually get to custody the pieces in the portfolio. [ Dilendorf ]
, the original DAO, was an investment vehicle through which members of
the Ethereum community pooled their assets to invest in crypto projects
for the purpose of getting a return on their money. While decentralized
in name, all proposals needed to be approved by the DAO “curators”. Due
to the outsized influence over the investment decisions by the creators,
the SEC decided the DAO tokens were securities. Ultimately, the project
flopped not because of the SEC’s decision but rather because the DAO was
hacked and lost half of its assets. Famously, the hack was reversed when
the Ethereum community hard forked to create a new asset, leaving behind
“Ethereum Classic”. [
The SEC determined XRP, the currency behind Ripple, to be a security because they argued that the value of XRP largely depends on the future efforts of the Ripple team. The Ripple CEO and the SEC are still working it out in court today.
The 2017 ICO boom saw the most truly fraudulent projects as well as the
fiercest action by the SEC. Many firms faced civil penalties and some
were forced to refund funds to investors. The outcome of your project
may depend on your intent as much as the rule of law. Those who make a
good faith effort to do right by their community, even if found to be
out of line of current legislation, often at worst end up needing to
return funds to investors. Those who make premeditated plans to
orchestrate a rug pull are likely to face harsh penalties.
Some relevant cases:
If ownership of your DAO is sufficiently distributed, and the future
success of your DAO is dependent on the collective effort of your
community, then your DAO token is unlikely to be a security based on
Alternatively, if your DAO has strong central leadership that owns a
meaningful stake, and the rest of the contributors are passive
participants hoping to see a return on capital based on the efforts of
the core team, then your DAO tokens are likely a security.
Equally important is the messaging used to promote your community. We commonly see members of the community promising that a token “will moon” in the near future. We see people advertising outsized future returns to encourage running up the price only to dump their position in the future. If people are buying your token solely because they are led to believe that they will be able to flip it for profit in the future, no matter your level of decentralization you may be putting investors at risk and piquing the interest of the SEC. The purpose of buying a DAO token should be to have ownership and governance power in a community that users actively want to participate in because they see benefit outside of potential token appreciation.
As much as we can learn from the past few years, this is an evolving space and it is important to be up to date and flexible as the regulatory environment evolves. While operating with the best intent for your users can help your case, ignorance is not a defense against blatant disregard of the law.